The Fed’s Inflation Battle Continues

August began as a strong month for the equity markets but ended on a weaker note. The S&P 500 finished the month down about 4.1%, while the Dow and the tech-heavy Nasdaq sank 3.7% and 4.5%, respectively. A volatile ride for stocks in the latter half of August has wiped out much of the market’s summer rally, with the S&P 500 erasing half of its gain since the mid-June low.

As we expected, the headline Consumer Price Index began to moderate in July with a significant decline in gasoline prices (down 7.7% over the month). Our forecast is for inflation to continue to moderate through the rest of the year, while remaining elevated. The continued decline in energy prices along with easing supply-chain stress data may imply another low headline inflation reading next month. However, the strong wage growth and higher shelter prices have more medium-term implications for the inflation outlook. Accounting for about 32% of the CPI index, rising shelter prices are likely to keep core inflation sticky. While growth in owners’ equivalent rent is expected to moderate with the cooling housing market, the under-supply of new homes supports inflationary pressures over the long term. Also, the Fed is concerned with wage growth. According to our wage index, the nominal wage growth shows no sign of decelerating. Our wage index (a combination of multiple wage measures including the employment cost index, the Atlanta Fed Wage Growth Tracker, and average hourly earnings) was up 6.3% YOY in July as compared with around 3.7% before the pandemic. The Fed will likely want nominal wage growth closer to 3.5% (sum of the 2% inflation target and 1.5% productivity growth).

The single month of lower inflation data in July falls far short of what the Fed is looking for, and Chair Powell’s speech at Jackson Hole economic symposium continued the hawkish tone of FOMC communications earlier in the month. Powell’s speech stressed that FOMC would seek out a “sufficiently restrictive” (versus the “moderately restrictive” stance in previous talks) policy stance to bring inflation back down to its 2% goal. In our view, there are three main messages in Powell’s brief remarks: 1) The speech reiterated the Fed’s “unconditional” responsibility and a strong commitment to restoring price stability regardless of the source of inflation; 2) The Fed Chair noted that there would be some pain for households and the overall economy due to tighter policy, indicating that the Fed will likely see a need for substantial tightening until more labor market softening emerges; and finally 3) The Fed needs to guard against the risks of declaring a premature victory over inflation by loosening policy too soon, implying that the schedule of market-implied 2023 easing might need to be pushed back. 

On the corporate front, the second quarter earnings reports were not overwhelmingly disappointing, but growing evidence has emerged from softening demand, inventory pressures, and consumer spending shifting from goods to services. In the aggregate, S&P 500 earnings increased by 6.7% in the second quarter, led by the energy sector. Excluding energy, however, earnings growth for the S&P 500 companies would flip from 6.7% to a negative 3.7% YoY. As we head into the seasonally more challenging period of the year for earnings revisions (mid-September to December), we believe that earnings expectations will be the key focus for the market. We see building margin pressure and earnings growth risks with inflation eating into margins, a narrowing spread between nominal GDP and wage growth, and the continuing downward trend of producers’ sentiment (PMI). Meanwhile, earnings revisions breadth for the S&P 500 is falling deeper into negative territory, indicating that more analysts are cutting their estimates rather than revising them higher. 

By the Numbers (Year-to-Date)*

U.S. Equities (S&P 500 Index) | -16.4%

International Equities (MSCI ACWI ex-U.S.) | -18.3%

U.S. Bonds (Barclays U.S. Aggregate Bond Index) | -10.8%

Global Bonds (JP Morgan Global Aggregate Bond Index) | -15.6%